Servicing Strip

What Is a Servicing Strip?

A servicing strip is a type of security created by the stream of cash flows that is backed from the servicing fee on a mortgage. A servicing strip is a small percentage of periodic loan payments as part of overall loan servicing.

Loan servicing refers to all of the administrative services that go into a loan, from sending out monthly statements to collection to record-keeping, managing accounts, and tracking overdue and delinquent accounts. Loan servicing can be performed by the institution or organization that issued the loan, such as a bank, or by a third-party vendor through or issued by the lending institution. Thus, a servicing strip may be induced by either the institution or the non-bank entity that performs the loan servicing, such as a Servicing Advance Facility.

Servicing strips are valuable because they trade in a secondary market much like mortgage-backed securities (MBS) do; the seller of the servicing strip has the ability to service the mortgage.

How Servicing Strips Work

Servicing strips have an embedded call option that may be exercised by the borrower, much like mortgage-backed securities. When a borrower pays off the mortgage, either through refinancing or by moving to a new residence, the serving strip goes away. The embedded option must be considered when performing a valuation of a servicing strip.

Aside from merely being a service fee, however, servicing strip are also part of loan servicing trades. One can think of mortgage servicing values as comparable to MBS interest-only strips. Servicing strips, however, carry a large amount of prepayment risk and thus have negative convexity.

The value of a service strip is determined by the cost comparison of the actual fee of servicing the loan to the amount charged. If the mortgage servicing fee is an excess of the cost of actually performing the service, the approximate cost difference represents the value of the servicing strip. The value of servicing strips can fluctuate in the market along with mortgage interest rates.

Example of a Servicing Strip

As an example of how a servicing strip can be collected, an individual or organization will issue the servicing strip, or servicing fee, as a percentage of one loan payment. The servicing strip tends to be around 0.25 percent to 0.5 percent of the loan payment.

For example, if the outstanding balance on a mortgage is $200,000 and the servicing fee is 0.25 percent, assuming there are 12 monthly payments, the servicer is entitled to retain approximately $41 per payment.